Clancy Yeates

The Reserve Bank has warned that moves to unleash more home loan competition could increase risk in the financial system, by pumping even more credit into the housing market.

With the big four banks controlling 80 per cent of the $1.3 trillion mortgage market, smaller lenders are ramping up pressure on the government to take steps they claim would help level the playing field.

A new submission from the Reserve Bank has cautioned against policies that could boost competition in home loans. Photo: Frances Mocnik

Regional banks, credit unions and building societies are this week urging the financial system inquiry, being chaired by former banker David Murray, to change regulations that give the Commonwealth Bank, Westpac, NAB, ANZ and Macquarie a significant cost advantage when making home loans.

But a new submission from the Reserve Bank has cautioned against policies that could boost competition in home loans, but come at the expense of financial stability.

The submission, published on Wednesday, warns that adopting competition policies raised in Mr Murray's interim report last month "could result in relatively more finance being directed towards housing," which it views as a source of "systemic risk" to the economy.

"The supply of mortgage finance in Australia is ample. Therefore, any proposed policies that could further increase that supply should be subject to rigorous analysis of their costs, benefits to consumers and risks to financial stability," its submission says.

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The central bank's comments highlight the balancing act confronting Mr Murray as he seeks policies that promote a competitive financial system without compromising stability.

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When the Coalition first pushed for the inquiry when in Opposition, competition was top of mind. This came amid concerns about big bank power after lenders' unpopular decisions on interest rates.

But the Reserve Bank said options to lift competition needed to be assessed with regard to their impact on the entire economy.

"Relevant considerations include whether the policy change might accelerate household borrowing and the associated implications for systemic risk and the available funding for Australian businesses," the submission said.

In their pleas for a level playing field, small lenders Bendigo and Adelaide Bank, Suncorp, Bank of Queensland and ME Bank are calling for a reduction in how much capital they must set aside as a buffer against home loans going sour.

Regional banks hold more than twice as much capital for every dollar lent out as the big banks. Mr Murray's interim report conceded this meant the market was not "competitively neutral" because it gave big banks a cost advantage.

However, the RBA's submission said it was "crucial" that any changes to capital rules did not trigger greater risk or amount to a weakening compared with global standards.

Despite the RBA's concerns, smaller banks maintained that reducing the capital gap between big banks and smaller lenders could instead help to reduce profit margins in home lending by lifting competition. This would act as a greater incentive for banks to lend to businesses, they said.

"Although not possible to prove that a future scenario will play out, the regional banks believe a closing in the capital gap will improve incentives for the supply of [small and medium enterprise] finance," they said.

The rapid growth in housing debt has emerged as a key concern facing the inquiry, with Mr Murray's interim report last month saying households' high leverage posed a "systemic risk" to the financial system. The share of bank loans used for housing has jumped from 47 per cent to 66 per cent since the last financial system inquiry in 1997.